by Calculated Risk on 1/20/2013 01:48:00 PM

A few thoughts on the "next recession" ... Forecasters generally have a terrible record at predicting recessions. There are many reasons for this poor performance. In 1987, economist Victor Zarnowitz wrote in "The Record and Improvability of Economic Forecasting" that there was too much reliance on trends, and he also noted that predictive failure was also due to forecasters' incentives. Zarnowitz wrote: "predicting a general downturn is always unpopular and predicting it prematurely—ahead of others—may prove quite costly to the forecaster and his customers".

Incentives motivate Wall Street economic forecasters to always be optimistic about the future (just like stock analysts). Of course, for the media and bloggers, there is an incentive to always be bearish, because bad news drives traffic (hence the prevalence of yellow journalism).

In addition to paying attention to incentives, we also have to be careful not to rely "heavily on the persistence of trends". One of the reasons I focus on residential investment (especially housing starts and new home sales) is residential investment is very cyclical and is frequently the best leading indicator for the economy. UCLA's Ed Leamer went so far as to argue that: "Housing IS the Business Cycle". Usually residential investment leads the economy both into and out of recessions. The most recent recovery was an exception, but it was fairly easy to predict a sluggish recovery without a contribution from housing.

Since I started this blog in January 2005, I've been pretty lucky on calling the business cycle.  I argued no recession in 2005 and 2006, then at the beginning of 2007 I predicted a recession would start that year (made it by one month with the Great Recession starting in December 2007).  And in 2009, I argued the economy had bottomed and we'd see sluggish growth.

Finally, over the last 18 months, a number of forecasters (mostly online) have argued a recession was imminent.  I responded that I wasn't even on "recession watch", primarily because I thought residential investment was bottoming. 

Now one of my blogging goals is to see if I can get lucky again and call the next recession correctly.  Right now I'm pretty optimistic (see: The Future's so Bright ...) and I expect a pickup in growth over the next few years (2013 will be sluggish with all the austerity).

The next recession will probably be caused by one of the following (from least likely to most likely):

3) An exogenous event such as a pandemic, significant military conflict, disruption of energy supplies for any reason, a major natural disaster (meteor strike, super volcano, etc), and a number of other low probability reasons. All of these events are possible, but they are unpredictable, and the probabilities are low that they will happen in the next few years or even decades.

2) Significant policy error. This might involve premature or too rapid fiscal or monetary tightening (like the US in 1937 or eurozone in 2012).  Two examples: not reaching a fiscal agreement and going off the "fiscal cliff" probably would have led to a recession, and Congress refusing to "pay the bills" would have been a policy error that would have taken the economy into recession.  Both are off the table now, but there remains some risk of future policy errors. 

Note: Usually the optimal path for reducing the deficit means avoiding a recession since a recession pushes up the deficit as revenues decline and automatic spending (unemployment insurance, etc) increases.  So usually one of the goals for fiscal policymakers is to avoid taking the economy into recession. Too much austerity too quickly is self defeating.

1) Most of the post-WWII recessions were caused by the Fed tightening monetary policy to slow inflation. I think this is the most likely cause of the next recession. Usually, when inflation starts to become a concern, the Fed tries to engineer a "soft landing", and frequently the result is a recession. Since inflation is not an immediate concern, the Fed will probably stay accommodative for a few more years.

So right now I expect further growth for the next few years (all the austerity in 2013 concerns me, especially over the next couple of quarters as people adjust to higher payroll taxes, but I think we will avoid contraction). I think the most likely cause of the next recession will be Fed tightening to combat inflation sometime in the future - and residential investment (housing starts, new home sales) will probably turn down well in advance of the recession. In other words, I expect the next recession to be a more normal economic downturn - and I don't expect a recession for a few years.